To state the obvious, only one of Paul Krugman and the late Hyman Minsky could have been right—either bank deposits are used to finance loans or loans create deposits—and it’s easy to verify which of the two understood banking.

That would be Minsky, who was one of a handful of prominent economists to have researched real-life banking practices and recognized that modern macro (in the profession’s mainstream of Keynesian,Monetarist, and New Classical thought) is fatally compromised by banking fallacies.

Sadly, though, his complaints had little effect—the profession’s mainstream chose not to debate the mechanics of bank loans. And that’s oddly revealing, knowing that economists love to debate. In contrast to the many economics debates that seem to go on forever, discussion rarely reaches bank lending mechanics, nor does it often acknowledge that mainstream theory gets those mechanics badly wrong.

Sure, you might occasionally hear an economist say, “Okay, fine, banks aren’t really just intermediaries like our textbooks say they are. Now move on, it’s not important.” But I wouldn’t call that a defensible position. I doubt it would even get a passing grade in my son’s monthly 7th.-grade social studies debates, considering that banks are, of course, vitally important.

You might have also heard economists claim to have fixed the banking errors by ducking under the hoods of their models and making just a few adjustments. That claim doesn’t pass the 7th.-grade debate standard, either, mainly because it’s untrue (as I discussed in more detail in earlier articles).

So macro persists with the same fatal flaws, and I persist in writing about how “the people” (or at least my readers) might identify risk indicators and other insights that mainstream theory fails to uncover, thanks to its false ideas about banks. If you don’t mind a brief advertisement, my bank-activity indicators have strong records predicting inflation and the business cycle, as discussed in “An Inflation Indicator to Watch,” Parts 1,2, and 3 and “A Recession Indicator for Independent Thinkers,” Parts 1 and 2.

But before my next update to the indicator series of articles, let’s try a slightly different approach. By sharing an excerpt from my book, Economics for Independent Thinkers,I’ll blend in the experiences of a new cast of characters. The first part of the excerpt rehashes the workings of bank credit cycles, using my own words. But the second part adds the other voices, and it’s a true hodgepodge: four savvy blog commenters, one modern-day Minskyite, and a centuries-old English matriarch. They make a strong team, in my opinion, and I hope they leave an equally strong impression. The full excerpt follows.

Hyman Minsky’s Second Heresy: Banks Matter

Even without his financial instability hypothesis, Minsky’s analytics alone would have banished him to the heretics’ corner. The problem was that he never went along with mainstream economists’ most glaring mistake—their naive and often fictitious view of bank lending. Theory holds that banks are merely intermediaries that receive deposits and then lend them out, with the deposits coming first and loans second. That leads economists to exclude banks from their models. Having imagined banks to be insignificant, model builders then pretend banking doesn’t exist.

In fact, bank lending in the real world and bank lending in mainstream theory are almost exact opposites. Real-world banks don’t wait for deposits before making loans; it’s the other way around. Banks create new deposits after loans are agreed, for that’s how they deliver the proceeds to the ultimate recipients. Loans come first, and deposits follow. The new deposits then slosh around from bank to bank as they’re used to pay for investments, goods, and services. But the deposits’ travels through the banking system have no bearing on future loan issuance, as theory suggests, because loans are matched with newly created, not old, deposits.

These facts of banking are important because they account for a significant source of economic volatility. Loans extended and retained by banks deliver an extra oomph that comes from deposits being created from thin air. Setting aside potential inflation effects, the extra deposits turbocharge the economy by injecting additional spending without any prior saving. More spending leads to more production, which leads to more income and reinforces the initial lift in spending, creating a “virtuous” loop. But turbocharged lending eventually reaches borrowers who produce things that can’t be profitably sold. Or it flows to home buyers and consumers who spend more than they can afford. Either way, loans go sour, and the virtuous loop may give way to a vicious loop of less lending, spending, production, and income.

The risks of bank lending are greater than the risks of debt financed by nonbanks, meaning any investing entity that’s not a bank. (I’m defining the term more broadly than in the financial industry’s references to nonbank financial institutions.) The key distinction is whether the lender’s claims on the borrower are held within or outside of the banking system. Lending that’s held outside of banks—either through debt security issuance to nonbanks or through loans that banks choose to sell to nonbanks—is funded by prior saving. Think of pension trusts, insurance companies, and households investing in bonds and bond funds—such nonbank investments are fundamentally different than the credit expansion that occurs when banks match loans with newly created deposits, thereby lifting the supply of credit without an earlier act of saving.

How to Collect “20 Rebuttals in 29 Comments”

Minsky added his voice to the medley of rebellious tunes—sung only in the profession’s underground—that include separate tracks for bank lending and nonbank lending. Some rebel vocals propose that banking practices need sweeping reforms. Others merely call for greater attention to the pros and cons of money creation through bank lending. But proponents of both causes agree that banks produce volatility that mainstreamers fail to account for.

Take Nobel laureate and Keynesian Paul Krugman. Krugman presented a paper in 2012, coauthored with Gauti Eggertsson, in which he claimed to channel Minsky but without reflecting Minsky’s knowledge of banks. Not surprisingly, his presentation failed to persuade the community of heterodox economists. Minskyite Steve Keen, for example, wrote a critical review that drew Krugman’s attention. Using the term neoclassicals for mainstream economists, Keen said,

Neoclassicals like Krugman read Minsky, and then proceed to build equilibrium models without banks, and think they’re modeling Minsky…

No they’re not…

One key component of Minsky’s thought is the capacity for the banking sector to create spending power “out of nothing.”

In the blogging brouhaha that followed, Krugman painted his critics as “all wrong.” Here are three telling excerpts from his side of the scuffle:

If I decide to cut back on my spending and stash the funds in a bank, which lends them out to someone else, this doesn’t have to represent a net increase in demand…

Banks don’t create demand out of thin air any more than anyone does by choosing to spend more; and banks are just one channel linking lenders to borrowers…

Any individual bank does, in fact, have to lend out the money it receives in deposits. Bank loan officers can’t just issue checks out of thin air … they must buy assets with funds they have on hand.

Notice that Krugman echoed the mainstream belief that banks act only as intermediaries, offering “just one channel linking lenders to borrowers.” Or, put differently, they lend the money they “receive in deposits.” He insisted that deposits come first and loans second, contradicting the true nature of bank lending. In reply, his blog commenters stole the show:

DAN NILE: I have worked in bank lending. Bank loan investors can in fact write checks out of thin air. … They are different from other financial intermediaries in having the privilege of issuing credit … at will.

NEIL WILSON: I would strongly suggest you spend some time at a bank and understand how they actually conduct operations. … Failure to understand the buffering nature of banks will lead you to the wrong economic model.

To close out the discussion—or at least his participation in it—Krugman appealed to the vocabulary of standard textbooks:

It’s obvious that many commenters don’t get the distinction between the proposition that banks create money—which every economics textbook, mine included, says they do (that’s what the money multiplier is all about)—and the proposition that their ability to create money is not constrained by the monetary base. Sigh.

I singled out Krugman only because the episode shows what can happen when scholars immerse themselves in abstract theory. He was so convinced by the theory he felt compelled to call his adversaries “banking mystics.” He didn’t know that the so-called mystics include the “Old Lady of Threadneedle Street,” otherwise known as the world’s second oldest central bank, the Bank of England.

What Would the Old Lady Say?

Two years after the blog exchange, the Old Lady published a report that was intended to clear up misconceptions found in textbooks, commentaries, and blogs. The report picked apart each of the claims Krugman made. On the idea that banks are merely intermediaries that can only lend the money they receive in deposits, the Old Lady stated,

Banks do not act simply as intermediaries, lending out deposits that savers place with them…

… Viewing banks simply as intermediaries ignores the fact that … commercial banks are the creators of deposit money. … The act of lending creates deposits—the reverse of the sequence typically described in textbooks.

She also corrected Krugman’s belief that money creation and lending are constrained by the amount of reserves, which are deposits held at the central bank that determine what Brits call central bank money and Americans call the monetary base:

In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. … The relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks…

… In no way does the aggregate quantity of reserves directly constrain the amount of bank lending or deposit creation.

And she rejected Krugman’s notion of a money multiplier:

Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money—the so-called “money multiplier” approach…

… In reality, the theory of the money multiplier operates in the reverse way to that normally described…

… New reserves are not mechanically multiplied up into new loans and new deposits as predicted by the money multiplier theory.

The last two fallacies—concerning the monetary base and money multiplier—may be a bit hazy if you’re unfamiliar with central banking practices. Not to worry—we won’t need to discuss them further. I included the fallacies here only because they contaminate a broad swath of mainstream theory.

But we’ll need to correct the more basic fallacies about money and banking. Money and banks give macroeconomics its shape and structure. If the subject has a spine, money and banks are the nerves and vertebrae. Yet economists have bungled them, as confirmed even by the Bank of England in its characteristically technical report. Had the Old Lady adopted the more plainspoken style of, say, Dorothy Parker, she may have concluded that your macro textbook is not something to be tossed aside lightly—it should be thrown with great force. That’s the approach I’ll take.

DANIEL NEVINS, CFA, has invested professionally for thirty years, including more than a decade at both J.P. Morgan and SEI Investments. He is perhaps best known for his behavioral economics research, which was included in the curriculum for the Chartered Financial Analyst® program and earned him recognition as one of the founders of goals-based investing. He has an economics degree from the Wharton School of Business and a degree from the University of Pennsylvania’s engineering school.blank text blank text blank text blank text blank text blank text blank text blank text blank text

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